Starz: Original Programming Revolution at a Price

The previous post in this series concluded that Starz (NASDAQ: STRZA  ) is desperately in need of a transition in strategy. Lacking negotiating leverage with customers and suppliers, the company is destined to be squeezed out of the premium cable market. The only way for it to survive is to develop original programming which will define the company's offering and help it to fight back against this intemperate industry structure.

A risky transition
The current plan for Starz is to keep developing original programming as content from Sony and Disney (NYSE: DIS  ) becomes more infrequent (due to fewer film releases) and replace all of the hours of content as Disney comes off in 2017. The total original programming addition to 2017 is about 40 hours.

At this price, investors seem fairly confident that the company can pull this transition off. There is good reason for this, as the company is led by Chris Albrecht, the former CEO of Time Warner Cable's  (NYSE: TWC  ) HBO who is credited with the success of shows like "Sex in the City" and "The Sopranos." Having such a well-known and skilled figure leading the transition is important. Distributors, as well as investors, can get behind him and buy into this transition. Albrecht's skills and leadership will be key to the success or failure of this strategy. 

That said, the transition to original programming is still a risky proposition, even with such talented leadership. Clearly, Starz does not have wide experience in the area. To mitigate this risk, Starz has adopted a "portfolio" approach to internal development using third parties to lessen the level of risk.

The portfolio approach to original programming
The riskiest choice when it comes to production is going it alone. "Spartacus" was developed internally and was modestly successful running for three series, averaging six million viewers per episode in the last season (this was just about the same as the last season of "Dexter" on Showtime and four million less than "Game of Thrones" on HBO). "Magic City" was also developed internally and is now in its second season, opening at 3.3 million viewers per episode. Starz bears most of the risk, but it can monetize its success across multiple platforms and regions.

"Da Vinci's Demons" was developed through a joint venture with the BBC and opened at 4 million viewers. The BBC paid 33% of the development cost for international rights in the UK and Benelux. "White Queen" was also developed through a similar structure.

Finally, Starz has licensed from Lionsgate and the Weinstein Brothers utilizing this structure for "Boss" and "Marco Polo." Neither was successful, however. Licensing removes the risk of cancellation costs, but the upside is limited to rights within its window. Renewing a successful show can also be expensive.

How much?
Developing an hour of content internally can cost as much as $3.5 million, so sharing the cost with third parties is a wise choice. The end of the Disney contract combined with the reduction of films released by Disney and Sony in the near future should open up some margin to develop content. If the company has trouble renewing with Sony then pressure on margins may become significantly more acute.

Estimates of incremental spending needed vary. To get to 80 hours of original programming, an extra $150-200 million will need to be spent. Another $50 million of margin will come back in 2017 as Disney rolls off, but this is still a substantial amount. The potential rewards are even larger though.

Dropping Disney was definitely the right choice, but investors should not forget that there will be a period when Starz is paying for both new content and for Disney content to make this strategy work. If the company does not gain any leverage with distributors, this will weigh heavily on profits.

Where is the upside?
As we know already, the problem with distributors is the weight of fixed-rate contracts. These fees are set to increase about 2%-3% annually, which will not meet the added spending on original programming alone. Changes in film output deal releases and the mix of wholly owned programming could add more margin, however. From this perspective, it is hard to be enthusiastic. Revenues are basically fixed while the whole cost structure of the programming is overturned. Benefits may never come, and if they do it will probably be in 2017. Investors appear to have been swept up in the euphoria around the sector, and two scenarios keep reappearing.

The first scenario is a merger. When Starz was spun off, John Malone highlighted the significant synergies that could be obtained in a merger with Starz. Exactly who would be the acquirer, though, is unclear.

Time Warner and CBS own HBO and Showtime, and as such the value of adding Starz for each of them is not clear. Disney is probably happy with the premium that it can obtain by licensing to third parties. Comcast already owns 6% of Starz, but signed a film distribution agreement with HBO for NBCU's Universal Pictures, as did Fox. Viacom, the owner of no. 4 premium cable channel EPIX, seems the most likely candidate. The question there is whether a combined Viacom/Starz would have enough leverage on distributors, although there would presumably be some useful synergies.

The other scenario is the spinning off of Anchor Bay, the home-distribution arm of Starz. Anchor Bay has a strategic partnership with Weinstein to distribute DVDs and digital/streaming content. A deal here seems unlikely, as Chris Albrecht suggested that Anchor Bay had a lot of distribution capacity and aims to bring in third-party products. The synergies in doing this would possibly be greater within Starz than outside.

Neither of these outcomes look particularly likely. The fashion of the day is to bet on all kinds of far out corporate restructuring, especially spin-offs, but management rarely sees things the same way. It is probably best that they don't, though, especially in industries like media.

The real source of upside here is the company's buyback program. Given the target of 2.5 times OIBDA/debt, I would guess the company can buy back about $200 million per year. Over three years, this would reduce the share count by 20%. At some point this sort of buying will require a new program, but I doubt that Malone will say no. Due to buybacks, earnings per share will probably grow faster than the increase in programming costs.

Summary
The upside at Starz is quite tangible and compelling. The buyback adds a lot of value and management has some experience in original programming. To gain any negotiating leverage, the company really needs to pull this off. This should light a fire under executives to make it work.

My concern is that the company is under a lot of cost pressure but has a limited scope for improving revenues quickly. If the strategy does not work, it will really go wrong. Negotiating leverage with customers and suppliers could disappear overnight.

For the risk, Starz is probably priced about right. If you believe in the original programming strategy (which I do) then I think Starz looks like a fair bet. Management look pretty good and the company's resources are, in my view, under-utilized. Even if you don't buy this scenario, Starz is one to watch. Transitions like this are highly complex and the road to 2017 will probably be a bit bumpy, throwing up a better opportunity for investors at some point.

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